1. TILTE: The FinancialCrisis: Who’s To Blame?
Damien MacFarland 7227484
INTRODUCTION:
People blame the banks for the financial crisis of the late-2000s; whereas the
banks blame the mathematicians. This essay, using a country ill-affected by the
financial crisis, will argue that the blame lies in human error.
The 1st part of this essay will review the financial crisis and its mathematical
structure. The 2nd part will examine the effect that it had on Germany. The final part
gives evidence that the people with the mathematics were the real perpetrators.
Looking at Germany’s stance through the financial crisis and how they’ve
come out the other side with little but a scratch in comparison to others can highlight
the foundations taken to ensure stability and thus act as a catalyst for others to
restructure and recover.
BACKGROUND:
Modern finance is dominated by differential formulas that produce
coefficients to measure the severity of risks that bankers, stock brokers, mortgage
lenders and politicians take to buy, sell, borrow and lend (OVERBYE, 2009a).
Mathematics is the modern basis of financial models. Since the 1970s mathematicians
and quantum physicists have been leaving the academia behind for a life where
numbers have greater rewards; and penalties (OVERBYE, 2009a). Deemed ‘The
Quants’ after their numbers had soared in the financial business, the biggest break-
through for those with science degrees came in the form of The Black-Scholes Model
which gave investors a sense of guaranteed profit (OVERBYE, 2009a).
David X. Li was a ‘Quant’; creator of the Gaussian Copula Function, he was
famous amongst his Wall Street peers; especially bond investors. In statistics a cupola
couples together the behaviour of several variables. Li’s formula allowed easier
modelling of risk; traders could now sell vast quantities of securities which lead to
massive borrowing within the bond and mortgage markets, especially in the United
States where the current financial crisis was said to kick start with the fall of house
prices and people owe in excess of $11 billion on their homes (SALMON, 2009b).
However the function was not bullet proof, but that didn’t mean that its usage was
going to stop. Cracks did appear and they grew but people were still making money
(SALMON, 2009b). Blythe Masters of Britain was part a team that worked for JP
Morgan on complex credit derivatives that allowed banks to spread their risk
elsewhere and thus needed less in reserve. The consequence: banks lent more
(TEATHER, 2008, p5).
We can see that mathematics has a huge part to play in modern finance and
allows it to function on a global scale. Complex derivatives have made it possible to
trade on a vast scale that yields massive return; spark human greed. Derivatives and
mathematical models within finance have led to large borrowing that was, based on
unstable parameters, not secure. Li’s cupola formula alone lead to $62 trillion in
outstanding credit default swaps by 2007, having only been invented at the start of the
decade, as traders were shifting their bonds (debt securities) aside (SALMON, 2009b)
The writing was on the ‘Wall’: 19th October 1987 was the darkest day on Wall
Street; christened Black Monday. It kick-started in the east and spread west; by the
time it reached the United States stocks had fallen by over 20% (OVERBYE, 2009a).
There was always evidence that things were not certain in finance but these signs
usually went ignored. More close to home, the crisis in Europe sprouted from “huge

2. internal imbalances” and “irresponsible lending to peripheral countries” (WOLF,
2011a, p11). Greece, one of 4 European countries in severe difficulty, has been issued
a bailout of €110 billion by the European Central Bank (ECB). This has been done
much to the annoyance of the German people, who abhor the ideas on bailouts that
their country has taken; the European giants are effectively rescuing their own savings
through bailouts and rescue plans having been one of the great lenders to these
peripheral countries in trouble (WOLF, 2011a, p11).
GERMANY:
Germany has been one of the main players within the Eurozone concerned
with bailouts to the likes of Greece, Ireland, Spain and Portugal, but how have they
got to this high level of security that they can afford drag others back to their feet?
Germany has always had territorial advantage within Europe; bordering 9
countries it is the link from Eastern Europe to the more developed West1. The USSR
had ruled the East under their communist ideals but the fall of the Berlin Wall in 1989
signalled change; there was now a “desire of Eastern Countries to join the European
Community”. The East was looking at West Germany to emulate their economy
which had a greater per capita income than that of the United States at the time
(MONTANI, 1993, p278).
Mario Draghi, Italy’s Central Bank chief, is a popular figure in Germany due
to his “tough standing on public finances”. He is seen as an ideal candidate to take the
next presidency of the ECB after Jean-Claude Trichets tenure expires. Trichet
flourished in his position and fought inflation rises based on the tradition of Germanys
Bundesbank (ATKINS, DINMORE, 2011b, p8). The German banking system has
always had a reputation as being hard-line and tough; this is why so many boards and
their presidents have adopted the German banking system as a catalyst. A sign of why
German banks have come out unscathed from the financial crisis.
German banks play a major role in the German system of finance for
investment. This system is composed of 2 parts:
(1) Large parts of funds for investment are provided in the form of bank loans
(2) Banks monitor the performance of firms closely and restructure them,
including management, where and when necessary.
As a result the banks are more willing to provide finance for long term investments
(EDWARDS, 1994, p1-2).
This long relationship between bank and firm enables the bank to understand
the business of the firm and its personnel to whom will be gaining control of the
funds. This can only put the bank in a more sound position to assess the risk of its
investment (EDWARDS, 1994, p9). They are also better placed to “control
managerial behaviour in the situation of financial distress” (EDWARDS, 1994, p97)
and fully support reorganization through the situation of distress (EDWARDS, 1994,
p176). Consequently, the German economy really benefits; there are no problems
with information between savers and investors and therefore investments are supplied
more efficiently; bans provide an efficient system of monitoring and replacing
managers within firms (EDWARDS, 1994, p11).
German firms don’t seem to be left to spend their funds freely; they always
appear to be well organized and well prepared to handle what investment they are
1 Germany borders with Denmark, Luxembourg, Belgium, Netherlands, France, Poland, Austria,
Switzerland, and Czech Republic.

3. given. No mathematics comes in to question here, only good management of
resources and good communication between firms and their investors.
On May 1st 2011, Germany is opening its borders to all of the European Union
which is estimated to see an influx of approximately 800,000 migrant workers from
Eastern Europe over the next 2 years. Trade unions have called for urgent measures to
be taken to prevent “wage dumping” as well as “unfair competition” for German
workers (PEEL, 2011b, p8). The German initiative is to be prepared and it stems
down to the trade unions. However, preparation does not exactly mean that the
migrant workers are going to be treated ill-heartedly nor does it mean that the natives
will be cast aside.
CONTRIBUTION:
Germany’s foundations seem to be sustainable; built for the long term
protection of its economy. Preparation, as well as efficiency, seems to go along with
structure and progress. The bank based system for investment allows for German
firms to take full advantage of their seat in the middle of the European Union, to trade
on an international scale and prosper to higher levels. Their banks have a popular
tradition, well coveted by others, that is run with a stern leadership; almost surely why
Frankfurt is the centre of European Banks. But where does mathematics come into all
of this?
In Germany, the mathematics does not seem to be the steam roller behind the
growth of the economy. Derivatives and cupola functions are not dished out to
bankers and brokers like evening meals. If a derivative for calculating risk was
conjured up in a German firm, the banks would have knowledge of it and wouldn’t let
it be used widely, especially not until it has proven how effective and accurate it is. It
seems that a ‘Schwarze Montag’2 would never develop in the German stock market or
that German firms would ever be involved in one.
In other developed countries the ones with the mathematical models and
formulas have been out of control and misguided in how to use the mathematics or
what it actually means. A prime example of this is in America and the case of David
X. Li’s Gaussian Cupola Function. The powers that be that were getting hold of it
were making decisions based upon a correlation figure that they knew little or nothing
about. The cracks were always there to see but were overlooked as the money that
was being made was too much to turn down. Directors of firms were always writing
reports upon how these mathematical models do not allow for the ever changing
market nor human change and natural events (SALMON, 2009b). Mike Brown of
Microsoft published a critique on modern finance asking for scientists and
mathematicians to reinvent modern finance instead of overloading it with formulas
that the majority can not use (OVERBYE, 20091). So not everyone on Wall Street
was throwing caution to the wind.
The formulas appeared to reduce risk in some areas but caused new risks to
grow in others; new risks that were not understood or as apparent.
Greed does come in a factor as to how mathematical models were abused and
tarnished. Banks and firms should have understood such models and used them with
care, with a plan b or at least a safety net. Caution is the word that springs to mind.
The world market is always changing; demand comes and goes, therefore firms, banks
and governments should be ready in the long term and make educated decisions with
the backing and support of their investors, like in Germany.
2 Translation: Black Monday

4. If ‘The Quants’ had more power or respect within the global market then it
would be more likely that decisions would be made based on better advice and solid
support. There is the argument that bad management decisions have been made during
the financial crisis i.e. it was not that the crisis was a result of people not
understanding the formulas but a failure of management to show them how or to
prevent their usage. That is why the German bank-based model for investment serves
as an example as to how change can take place in firms of other developed countries
to prevent a future crisis. Mike Browns argument is also strong but perhaps it has to
follow in a national shake-up of financial systems of investment in these countries.
CONCLUSION:
In Germany things seem to be done differently. Although they were not 100%
correct in their decisions through out this latest financial crisis, with them being a big
lender themselves, but internally they set a good example of how to structure
countries finances. Mathematics will forever be used within the financial sector,
however the human factor will always come into financial decisions in the end and
whether they are right or wrong; hopefully in the future they will be better supported.
“As Li himself said of his own model: "The most dangerous part is when
people believe everything coming out of it."” (SALMON, 2009b)
REFERENCES:
TYPE OF REFERENCE: EXAMPLE OF REFERENCE:
Book  Edwards, Jeremy (1994) Banks, Finance and
Investment in Germany, Cambridge
University Press
Article in Book  Montani, Guido (1993) International
Democracy and Economical Development in
Gianni Vaggia’s From the Debt Crisis to
Sustainable Development, St. Martin’s Press
Article in Newspaper  Atkins, Ralph and Dinmore, Guy (2011b)
‘ECB Look Set to Adopt Tough New Style’
Financial Times, 27th April 2011, p8
 Overbye, Dennis (2009a) ‘They Tried to
Outsmart Wall Street’ New York Times, 10th
March 2009
 Peel, Quentin (2011b) ‘Germany Faces Big
Inflow of Workers’ Financial Times, 27th
April 2011, p8
 Teather, David (2008) ‘The Woman Who
Built Financial Weapon of Mass Destruction’
The Guardian, 20th August 2008, Top Stories
section: p5
 Wolf, Martin (2011a) ‘The Grand Bargain is
Just a Start’ Financial Times, 30th March
2011, p11
Article in Magazine  Salmon, Felix (2009b) ‘Recipe for Disaster:
The Formula That Killed Wall Street’ Wired
Magazine, 23rd February 2009